Financial Fragility: Issues and Policy Implications

Abstract

This article addresses the question of how financial institutions, contracting forms, and government financial policies affect the degree of macroeconomic volatility. Models that posit such relationships are sometimes referred to as models of “financial fragility.” These models explore ways in which the financial system can add to the volatility of economic activity by defining sources of financial “shocks” and financial “propagators” of other shocks. Financial shocks are defined as disturbances to the real economy that originate in financial markets. Financial propagation refers to the ways in which financial contracts, markets, and intermediaries can serve to aggravate shocks that originate elsewhere. Economists have not always been receptive to the idea that financial arrangements matter for business cycles. From the standpoint of traditional neoclassical general equilibrium theory, financial arrangements (which include financial contracting, the actions of financial intermediaries, and government policies toward the financial sector) typically are viewed as epiphenomenal—simply as a set of mechanisms for executing ArrowDebreu contingent claims to allocate resources optimally. Mainstream macroeconomists and finance specialists of the 1960s seemed to agree.1 Corporation financial decisions were neutral according to Modigliani and Miller (1958), with the addition of minor caveats to take account of physical bankruptcy costs and tax incentives; and firms all faced identical costs of funds adjusted for systematic risk factors according to the capital asset pricing model. Thus, there was no call to object to the standard IS-LM macroeconomic framework’s assumption that all firms effectively faced the same cost of funds (summarized by “the” interest rate) and that this cost equaled the marginal product of capital.

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